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School of Law Dean Emeritus Henry Manne takes a look at the logic of behavioral finance, "a developing field of academic research that emphasizes investor irrationality (and ignorance) and the inefficiency of markets" and which has been "hailed by defenders of the SEC as offering a solid economic rationalization for our vast scheme of federal securities regulations" in the first of a two-part series in The Wall Street Journal.

Excerpt:"The literature on prediction markets makes clear that the more participants in a contest and the better informed they are, the more likely is the weighted average of their guesses to be the correct one. That is true, ironically, even though the additional participants have even less knowledge than the earlier ones. The only requirements for these markets to work well are that the various traders be diverse and that their judgments be independent of one another. Clearly, there is still a lot more work of a statistical and mathematical nature to be done before the idea of the wisdom of crowds is turned into a full-fledged theory of price formation, but at least we have identified the problem and made a start towards a solution.

"The implications of what we already know of this 'wisdom of crowds' approach to price formation, as against the traditional marginal pricing/arbitrage approach, are apt to be startling. We should rethink any current policies based on a view of pricing in which we exclude the best-informed traders and discard the wisdom of the many. For instance, we now have a new and more powerful argument than we had in the past for legalizing most insider or informed trading.

"Since such trading clearly makes the market process work more efficiently, it aids capital allocation decisions and informs business executives through market-price feedback of the best predictions about the value of new plans. Furthermore, the Supreme Court's 'fraud on the market' theory of civil liability under the federal securities laws and Congress's ideas of correct civil damage claims for insider trading no longer have any intellectual merit. The same is true of any other part of our securities laws implicitly based on the notion of the marginal trader as a rational arbitrageur of price.

"The new approach would suggest that it is undesirable to have laws discouraging stock trading by anyone who has any knowledge relevant to the valuation of a security. Thus, assembly-line workers, administrative assistants, office boys, accountants, lawyers, salespeople, competitors, financial analysts and, of course, corporate executives (government officials are another story) should all be encouraged to buy or sell stocks based on any new information they might have. Only those privately enjoined by contract or other legal duty from trading should be excluded. The 'wisdom of crowds' can do far more for the welfare of American investors than all the mandated disclosures and insider trading laws that the SEC and Congress can think up."